Slouching Towards Utopia?: The Economic History of the Twentieth
Century

-XXIII. Inflation and Oil Shocks: The End of the Keynesian Era-

J. Bradford DeLongUniversity of California at Berkeley and NBER

February 1997

The Misfortunes of Prosperity

Hubris

Stagflation

The Fall of Bretton Woods

Oil Shock and Productivity Slowdown

The Late 1970s

The Volcker Disinflation

The Misfortunes of Prosperity

As time passed, and the memory of the Great Depression
dimmed, governments' commitments to fight unemployment fiercely
even at the cost of risking some infiation began to fiag. This
became of great importance because the post-World War II economic system's
ability to deliver low unemployment without high infiation began to
erode as well.

Between 1954 and 1969--between the Korean War and the
height of the Vietnam War-it looked as though the U.S. economy was sliding
back and forth along a stable infiation--unemployment "Phillips
Curve." Democratic governments tended to spend more time at the left
end of the curve, with relatively high infiation and relatively low
unemployment. Republican governments tended to spend more time at the right
end, with low infiation and higher unemployment. But by absolute and
by historical standards, both infiation and unemployment were low.

The first sign that something had changed came during
Richard Nixon's first term as president. He attempted to move the
economy from the left to the right side of the 1954­69 curve, and found
that it would not go. 1970­1973 saw unemployment and infiation
both at high levels relative to the previous post-World War II experience
(although still at low levels absolutely). After some thought, a consensus
was reached: tight monetary policy and attempts to fight infiation
by marginally increasing unemployment no longer worked because no one believed
that such efforts would be continued very far.

Auto workers, say, believed that the government would
not allow widespread unemployment in the automobile industry--that the
government would pump up nominal demand to give people enough liquidity
to buy cars if ever the industry's sales began to drop. This left the United
Auto Workers, therefore, with no incentive to moderate its wage demands-it
was not risking serious unemployment on the part of its members if it did
so. And this left the automobile manufacturers with no incentive to resist
demands for higher wages: they could simply pass them on in higher prices.
And so the economy had grown "used to" steady infiation
at five percent per year.

How to deal with this dilemma? One possibility was that
the government should create a truly massive recession-should make it painfully
obvious that if infiation rose too high and if wages agreed on by
workers and firms rose too rapidly, the government would not accomodate,
would not expand nominal demand, but would instead infiict unemployment
and keep unemployment high until infiation came down. No president
wanted to think about this possibility. It was, in the end, the road the
United States took, but largely by accident and after many stopgaps. And
taking this road led to the end of the most successful economic order the
industrial world had seen.

Hubris

In 1960 two prominent liberal economists--both future
Nobel Prize winners--Paul Samuelson and Robert Solow wrote an article in
which they attempted to quantify how low the government could push unemployment:

...In order to achieve the nonperfectionist's [emphasis
added] goal of high enough output to give us no more than 3 percent unemployment,
the price index might have to rise by as much as 4 to 5 percent per year.
That much price rise would seem to be the necessary cost of high employment
and production in the years immediately ahead.

All this is shown in our... Phillips curve [diagram]....
The point A, corresponding to price stability, is seen to involve about
5.5 percent unemployment; whereas the point B, corresponding to 3 percent
unemployment, is seen to involve a price rise of about 4.5 percent per
annum. We rather expect that the tug of war of politics will end us up
in the next few years somewhere in between...

The surprising thing is that three percent unemployment--a
goal outside the historical operating range of the peacetime economy, a
level of unemployment that had been reached in the United States only in
response to the shock of a major war--as a "non-perfectionist's goal."
If a non-perfectionist would demand that the economy do better than it
ever had before in peacetime, what would a perfectionist have demanded?

Now Paul Samuelson and Robert Solow were not exceptional.
In 1969, the former Chair of the Council of Economic Advisers, Arthur Okun,
was publicly calling for a long-term "4 percent rate of unemployment
and a 2 percent rate of annual price increase" as "compatible"
what he called "an optimistic-realistic view" of the structure
of the American economy--and as a target worth aiming at. The post-World
War II U.S. had managed to attain his target in only one single year. Yet
Arthur Okun believed that proper demand management of the economy could
produce results better than had been achieved before

This is hubris: overpowering pride that sets itself up
for nemesis, the revenge that things take because one's reach exceeds one's
grasp. One explanation for this hubris--this belief that proper demand
management policy could induce the economy to do things it had never done
before--is that it was part of the legacy left by John Maynard Keynes's
Theory of Employment, Interest, and Money. Indeed, Chicago-school
economist Jacob Viner's review of The General Theory had forecast
that:

In a world organized in accordance with Keynes' specifications,
there would be a constant race between the printing press and the business
agents of the trade unions, with the problem of unemployment largely solved
if the printing press could maintain a constant lead...

And he gloomily called the General Theory a "book
which is likely to have more influence than it deserves." You could
not ask for a better prediction.

But it is more accurate to see the views of Arthur Okun
and company as a consequence of the very long shadow cast by the Great
Depression. The Great Depression had broken any link that might ever have
been drawn between the average level of unemployment over any time period,
and the desirable, attainable, or sustainable level of unemployment. With
the memory of the Great Depression still fairly fresh, it was extremely
difficult to argue that the normal workings of the business cycle
led to fiuctuations around any sort of equilibrium position.

There was "frictional" unemployment--workers
looking for jobs and jobs looking for workers before the appropriate matches
had been made--which served as a kind of "inventory" of labor
for the economy. There could be "structural" unemployment-- people
with low skills in isolated regions where it was not worth any firm's
while to employ them at wages they would accept--which could not be tackled
by demand-management tools.

Everything else was "cyclical" unemployment:
a smaller case of the same disease as the unemployment of the Great Depression,
which could presumably be cured by the standard expansionary policy means
that economists' believed would have cured the Great Depression if they
had been tried at the time.

The Great Depression had taught everyone the lesson that
business cycles were shortfalls below, and not fiuctuations around,
sustainable levels of production and employment. As of the start of the
1960s, there was no good theory to explain why "frictional" and
"structural" unemployment should even together add up to any
significant fraction of the labor force. Thus anyone-it did not have
to be John Maynard Keynes-developing a macroeconomics in a context in which
the Great Depression was the dominant empirical datum would find that
the path of least resistance led to expansionary policy recommendations:
Depression-level unemployment certainly did not serve any useful economic
or social function; the bulk of observed post-World War II unemployment
looked like Depression-era unemployment; therefore policy should be expansionary.

Did economists' overoptimism matter? Did it make a difference
that they were talking at the beginning of the 1960s of 3 percent unemployment
as a "nonperfectionist" goal, and were arguing at the end of
the 1960s that 4 percent unemployment and 2 percent infiation was
likely to be a sustainable posture for the American economy over the long
run?

During periods of Republican political dominance, perhaps
not: the 1950s saw not gap-closing but rather stabilization policies of
the kind that Herbert Stein had pushed for from the CED, as Eisenhower's
economic advisers balanced between Keynesians to the left and residual
Hooverites to the right. But during periods of Democratic political dominance,
economists' overoptimism almost certainly did matter.

The core of the Democratic political coalition saw every
level of unemployment as "too high." And economists' professional
opinions about what was and was not feasible, given the policy tools at
the U.S. government's disposal, were in a sense the only possible brake
on the natural expansionary policies that would have been pursued in any
case by the post-World War II Democratic Party.

Perhaps economic advisors would have proven irrelevant
in any case. If the profession had been less heavily concentrated toward
the Keynesian end of the spectrum, and if Walter Heller and James Tobin
had possessed views on macroeconomic policy like those of Arthur Burns
and Herbert Stein, perhaps President Kennedy's economic advisors would
have had other names.For every conceivable policy
there is an economist who can wear a suit and pronounce the policy sound
and optimal, and that to a large degree Presidents and Senators get the
economic advice that they ask for. Perhaps a less optimistic group of advisors
drawn from the academic economics community would have had no more effect
on macroeconomic policy in the 1960s than advisors from the academic economics
community had on fiscal policy at the beginning of the 1980s when
they pointed out that revenue projections seemed, as former Reagan-era
CEA chair Martin Feldstein very politely put it, "inconsistent with
the Federal Reserve's very tight monetary policy."

Sooner or later, the turning of the political wheel would
bring a left-of-center party to effective power in the United States. And
when that happened everything--the memory of the Great Depression, the
elements of that party's core political coalition, the theories of economists
in the mainstream of the profession--would push for policies of significant
expansion.

If 4 percent unemployment had turned out to be consistent
with relatively stable inflation, the cry would have arisen for a reduction
in unemployment to 2 percent. Sooner or later a liberal government would
have pushed total demand beyond the economy's capacity to produce without
accelerating inflation. And it happened that this sooner or later turned
out to be the late 1960s and eary 1970s.

It is well within the bounds of possibility that the U.S.
might have avoided a burst of infiation in the late 1960s and early
1970s. But then it would have been vulnerable to an analogous burst of
infiation in the late 1970s, or in the early 1980s. And if infiation
had been avoided through the early 1980s, analogous policy missteps might
well have generated infiation in the late 1980s. The "monetary
constitution" of the U.S. at the end of the 1960s made something like
the 1970s, at some time, a very likely probability. And I do not see how
the "monetary constitution" could have shifted to anything like
its present state in the absence of an object lesson, like the experience
of the 1970s.

Stagflation

From 1954 to 1968, the relative levels of infiation
and unemployment in the United States moved back and forth along a stable
curve that came to be called the "Phillips Curve." Democratic
governments tended to want to position the economy at the left end of the
curve, with relatively low unemployment and moderate infiation. Republican
governments teneded to want to position the economy at the right end of
the curve, with moderate unemployment and low infiation.

Few economists, politicians, or bureaucrats in the middle
1960's disagreed with Johnson economic advisor Walter Heller, who said
that opinion now took it "for granted that the government must step
in to provide the essential stability [of the economy] at high levels of
employment and growth that the market mechanism, left alone, cannot deliver."

By the beginning of 1969, the U.S. had already finished
its experiment: was it possible to have unemployment rates of four percent
or below without accelerating infiation? The answer was reasonably
clear: no. Average nonfarm nominal wage growth, which had fiuctuated
around or below four percent per year between the end of the Korean War
and the mid-1960s, was more than six percent during calendar 1968.

By the early 1970s the low-infiation low-unemployment
Keynesian order had definitely broken down. As economist Robert Gordon
wrote, looking back, "[t]his framework collapsed with amazing speed
after 1967. My graduate school classmates and I were acutely aware of the
timing of this turn of the tide, as we began our first teaching jobsand
almost immediately found our graduate school education incapable of explaining
the evolution of the economy." Kennedy and Johnson economic advisors
had argued that a substantial reduction in unemployment could be achieved
with only a moderate increase in infiation. But as Vietnam War spending
overheated the economy from 1966­1969, unemployment did not drop much
and infiation accelerated far beyond the expectations of Keynesian
analysts.

The newly-elected Republican administration of Richard
Nixon sought to move the economy back to the right end of the Phillips
curve, and hoped to attain a cooling off of infiation at the cost
of only a small increase in unemployment. But their policies only half
worked: unemployment did indeed rise from 3 1/2 to almost 6 percent from
1969 to 1971, but infiation did not decline. The failure of infiation
to fall led the Nixon administration to abandon its non-interventionist
principles, and to impose stringent price controls for 90 days and then
further "phases" of price and wage controls thereafter.

The period of price controls did see a small deceleration
of infiation. It was, however, accompanied by a surge of demand pushed
by an expansionary monetary policy: to some degree, the Federal Reserve
misread how expansionary its policies were, and to some degree the Federal
Reserve was anxious to please Nixon, who did not want to enter the 1972
election campaign season with a rising unemployment rate. Nixon recalled
how in 1960 he and Arthur Burns--in 1972 Federal Reserve chairman--had
gone to President Eisenhower, begged Eisenhower not to let unemployment
rise during the 1960 year, and how Eisenhower had then turned him down.

Nixon had then lost the 1960 election to John F. Kennedy.

Thus President Nixon was extremely unwilling to back any
moves toward placing reducing inflation ahead of reducing unemployment.
Democrats in Congress agreed that Nixon's policies were too "deflationary".
And Federal Reserve Chair Arthur Burns did not think that it was politically
and economically possible in the early 1970s to fight inflation by inducing
a recession.

Could such a reduction in inflation have been accomplished
at the end of the 1960s? At a technical level, of course it could have.
Consider infiation in the five largest industrial economies,
the G-5. Before the breakdown of the Bretton Woods fixed exchange-rate
system, the price levels in these five countries are loosely linked
together. But the Bretton Woods system breaks down at the beginning of
the 1970s, and thereafter domestic political economy predominates as infiation
rates and price levels fan out both above and below their pre-1970 track.

West Germany was the first economy to undertake a
"disinfiation." The peak of German infiation in the
1970s came in 1971: thereafter the Bundesbank pursued policies that accomodated
little of supply shocks or other upward pressures on infiation. The
mid-1970s cyclical peak in infiation was lower than the 1970-71 peak;
the early-1980s cyclical peak in West German infiation is invisible.Japan began its disinfiation in the mid-1970s, in spite
of the enormous impact of the 1973 oil price rise on the balance-of-payments
and the domestic economy of that oil import-dependent country.

The other three of the G-5--Britain, France, and the United
States--waited until later to begin their disinfiations. France's
last year of double-digit infiation was 1980. Britain's last year
of double-digit infiation was 1981. Certainly there were no "technical"
obstacles to making the burst of moderate infiation the U.S. experienced
in the late 1960s a quickly-reversed anomaly.

But Arthur Burns had no confidence that he could reduce
inflation at a price in terms of higher unemployment that the economy was
willing to pay. In 1959 Arthur Burns had given his presidential address
to the American Economic Association. His presidential address was called,
"Progress toward Economic Stability." Burns spent the bulk of
his time detailing how automatic stabilizers and monetary policy based
on a better sense of the workings of the banking system had made episodes
like the Great Depression of the past extremely unlikely.

Toward the end of his speech, Burns spoke of an unresolved
problem created by the progress toward economic stability that he saw:
"a future of secular infiation":

During the postwar recessions the average level of prices
in wholesale and consumer markets has declined little or not at all. The
advances in prices that customarily occur during periods of business expansion
have therefore become cumulative. It is true that in the last few years
the federal government has made some progress in dealing with infiation.
Nevertheless, wages and prices rose appreciably even during the recent
recession, the general public has been speculating on a larger scale in
common stocks, long-term interest rates have risen very sharply since mid-1958,
and the yield on stocks relative to bonds has become abnormally low. All
these appear to be symptoms of a continuation of infiationary expectations
or pressures...

Before World War II such infiationary expectations
and pressures would have been erased by a severe recession, and by the
pressure put on workers' wages and manufacturers' prices by falling aggregate
demand. But Burns could see no way in which such pressures could be generated
in an environment in which workers and firms rationally expected demand
to remain high and recessions to be short.

Burns's skepticism about the value of monetary policy
as a means of controlling infiation in the post-World War II era was
reinforced by the pressure for avoiding any significant rise in unemployment
coming from his long-time ally, patron, and friend, President Nixon, and
from the Democratic leaders of congress.

Arthur Burns played a key role in the Nixon administration's
eventual adoption of a wage-price freeze in late 1971. The context was
one of a Council of Economic Advisers averse to all forms of incomes policy,
from guideposts on up, as "wicked in themselves and steps on the slippery
slope... to controls"; of a President who "did not like 'incomes
policies' and knew they did not fit with his basic ideological position";
and of an opposition party that had a "great interest in pointing
out that there was another, less painful, route to price stability [than
gradualism and recession], which Mr. Nixon was too ideological to follow."
And Burns's intervention on the pro-controls side so that "every editorial
writer who wanted to recommend some kind of incomes policy could say that
'even' Arthur Burns was in favor of it" led Stein to liken:

the administration...[to] a Russian family fieeing
over the snow in a horse-drawn troika pursued by wolves. Every once in
a while they threw a baby out to slow down the wolves, hoping thereby to
gain enough time for most of the family to reach safety. Every once in
a while the administration would make another step in the direction of
incomes policies, hoping to appease the critics while the [gradualist]
demand management policy would work. In the end, of course, the strategy
failed and the administration made the final concession on August
15, 1971, when price and wage controls were adopted...

Rockoff (1984) finds nothing good in the 1971-1974
experience with controls. The controls did not calm infiationary expectations.
Instead, they appear to have created them-with a general expectation that
prices would rebound once the controls were lifted. The controls imposed
the standard microeconomic, compliance, and administrative costs on the
American economy. Perhaps most serious, the fact that wage and price controls
were still in effect in the fall of 1973, when the price of oil jumped,
created a substantial divergence between the cost of energy to U.S. users
and the world price of energy, which slowed down the process of adjustment.
Energy price controls remained, until eliminated as one of the good deeds
of the Reagan administration in the early 1980s.

And perhaps the controls led to overoptimism, and hence
to looser monetary and fiscal policy than would have otherwise been
put in place, because of their apparent initial success.

If the apparent initial success of the Nixon controls
program did lead to overoptimism about how much more monetary and fiscal
restraint was necessary to contain infiation, the Nixon administration
suffered less from such overoptimism than did its critics.Walter Heller,
one o fhte most prominent Democratic economists of the early 1970s, testified
before Joint Economic Committee on July 27, 1972 on how Nixon administration
policy was too contractionary: "As I say, now that we are again on
the [economic] move the voice of overcautious conservatism is raised again
at the other [White House] end of Pennsylvania Avenue. Reach for the [monetary]
brakes, slash the [fiscal] budget, seek an end to wage-price restraints."

And private-sector forecasters agreed. One of the striking
features of the infiation of the 1970s was that increases in infiation
were almost always unanticipated. The figure below plots the average
forecast for the forthcoming calendar year, made as late in the year as
possible, from the survey of professional forecasters alongside actual
December-to-December GDP defiator infiation. In every single
year in the 1970s, the consensus forecast made late in the previous year
understated the actual value of infiation.

Even if the Johnson-era infiation had not already
done so, the first Nixon administration destroyed investors', firms',
and workers' confidence in the nominal anchors of the economy. Before
the mid 1960's, infiation in the United States (outside of wartime)
was something that academic economists worried, but was outside the realm
of considerations important enough to enter the calculations of other people.
As a result, the economy moved back and forth along the Phillips Curve-moving
up and to the left with higher infiation and lower unemployment when
total demand was high and wages rose, moving down and to the right with
lower infiation and higher unemployment when total demand was low-which
was set in its position because by and large investors, firms, and
workers did not think that shifts in the rate of infiation were enough
to worry about.

By the early 1970s this had changed: everyone knew that
a raise or an interest rate of 6 percent over a year was no interest rate
at all, because infiation ate away the whole increase. As a result,
when demand was tight and workers could press for higher wage settlements,
they would press for enough to cover expected infiation, plus a real
wage increase-plus enough to cover the extra infiation that would
come about in the economy as a whole because demand was tight. This meant
that throughout the 1970's, any move to reduce unemployment would provoke
an immediate upward jump in infiation and interest rates. President
Carter thus went into--and lost--the 1980 election with 7 percent unemployment
and 9 percent infiation. He was followed by a Republican administration
that in many respects saw not only the 1970's but also the 1960's-and,
indeed, the entire post-World War II Keynesian order-as a series of mistakes.

The End of Bretton Woods

There were two other major events in the early 1970's
that in prospect were seen as sideshows, but that in retrospect played
as large or larger a role in the end of the great post-World War II Keynesian
boom as the erosion of the Phillips Curve. The first was the casual
destruction of the Bretton Woods arrangements, which had preserved almost
all of the benefits of fixed exchange rates while granting the
fiexibility to change exchange rates to adjust to major economic shifts
that the gold standard had lacked. The system posed an obstacle to Nixon's
and Treasury Secretary John Connally's plans to use price controls to reduce
infiation while reducing unemployment to increase the chances of reelection:
the resulting large trade deficit would either require higher interest
rates to finance the balancing infiow of capital--which would
tend to raise unemployment--or devaluation. Under the Bretton Woods system
the United States could not devalue without the agreement of other countries
because all other countries defined their currencies as given fractions
or multiples of the dollar, and this agreement was not readily forthcoming.
So it was abandoned and the U.S. forced the move to the current system
of freely-fioating exchange rates, which has not served the world
economy well.

Thus there is a very real sense in which monetary policy
did not contain infiation in the early 1970s because it was not tried.
And it was not tried because the Chairman of the Federal Reserve did not
believe that it would work at an acceptable cost. Even the threatening
breakdown of the fixed exchange rate system, which Burns "feared...
with a passion," would not induce Burns to tighten sufficiently
to risk a more-than-moderate recession. Paul Volcker reports an "interesting
discussion with Arthur Burns" over lunch at the American embassy in
Paris, at which "the Chairman of the Federal Reserve Board made one
last appeal" to retain a system of fixed exchange rates (see
Volcker and Gyohten (1992)). Volcker reports that:

To me, it simply seemed too late, and with some exasperation
I said to him "Arthur, if you want a par value system, you better
go home right away and tighten money." With a great sigh, he replied,
"I would even do that..."

The Oil Shock

The second event was the tripling of world oil prices
in the fall of 1973. This sent the world economy into a major recession
accompanied by rapid infiation, and pushed the world economy toward
a much more energy-conserving pattern of production. Somewhat paradoxically,
the rational-expectations school of economics that would have given advance
warning of the breakdown of the Phillips Curve, and had as a result become
dominant, believed that the tripling of world oil prices was macroeconomically
irrelevant: the oil price would rise, other prices would fall, and the
overall price level would be unaffected because the general price level
was determined by the money supply and not by decisions of producers of
individual commodities to raise prices. The tripling of oil prices sent
the world economy into one of the deepest recessions of the post-World
War II period, and left the economy with the legacy of high infiation
that would in its turn lead to the 1980­82 recession, the deepest of
the post-World War II era.

It is possible that the tripling of world oil prices was
an intended result of U.S. foreign policy. Nixon's chief foreign policy
advisor, Henry Kissinger, wanted to strengthen the shah of Iran as a possible
counterweight to Soviet infiuence in the middle east. With the oil
price tripled, the shah was indeed immensely strengthened-at the price
of enormous economic damage to the industrial west and to the rest of the
developing world, which saw its oil bill multiplied manyfold. It is certain
that the economic repercussions of the oil price rise came as a surprise
to the Nixon administration-Kissinger always thought economic matters were
boring and unimportant in spite of the fact that the military and diplomatic
strength of the United States depended on and should have been used to
safeguard the liberty and prosperity of the United States.

It is most likely that the oil price rise struck the administration
as not worth its concern, and certainly as not worth trying to roll back--it
did, after all, strengthen the shah, few had any conception of the economic
damage it might do, and those few were not listened to by the U.S. government.

Alan Blinder, Vice Chair of the CEA and of the Federal
Reserve in the 1990s, argued that double-digit infiation in the 1970s
had a single cause: supply shocks that sharply increased the nominal prices
of a few categories of goods, principally energy and secondarily food,
mortgage rates, and the "bounce-back" of prices upon elimination
of the Nixon controls program. Such shocks were arithmetically responsible
for, in Blinder's words, "the dramatic acceleration of infiation
between 1972 and 1974....The equally dramatic deceleration of infiation
between 1974 and 1976....[And] while the rate of infiation.... rose
about eight percentage points between 1977 and early 1980, the 'baseline'...
rate may have risen by as litle as three."

Arithmetic decompositions of the rise in infiation
into upward jumps in the prices of special commodities were never convincing
to those working in the monetarist tradition. As Milton Friedman asked:

The special conditions that drove up the price of oil
and food required purchasers to spend more on them, leaving them less to
spend on other items. Did that not force other prices to go down, or to
rise less rapidly than otherwise? Why should the average [emphasis in original]
level of prices be affected significantly by changes in the price
of some things relative to others? (Friedman (1975), cited in Ball and
Mankiw (1995))

But the missing link in Blinder's argument can be provided
by noting that the oil price increase entailed large increases in the prices
of goods in a few concentrated sectors. They reduce nominal demand for
products in each unaffected sector by a little bit. Small administrative
or information processing costs might plausibly prevent full adjustment
in many of the unaffected sectors, leaving an upward bias in the overall
price level. Concentrated shocks that are (a) significantly larger
than the average variance of shocks but (b) not so large as to require
relative price movements that overwhelm administrative and information
processing costs in all sectors appear to have the best chance of generating
large upward boosts in infiation.

The Productivity Slowdown

Possible causes

The oil shock

Environmental spending

The exhaustion of the Great Depression's backlog of inventions

A low pressure economy

Effects

Politics turns nasty

The crisis of the social welfare state

The Late 1970s

Each surge in infiation was quickly followed by--or
in the case of the mid-1970s oil shock infiation cycle roughly coincident
with--an increase in unemployment. Once again, each cycle in the late 1960s
and 1970s was larger than the one before: unemployment peaked at around
6 percent in 1971, at about 8.5 percent in 1975, and at nearly 10 percent
in 1982-83.

The recession of 1974-1975 made it politically dangerous
to be an advocate of restrictive monetary policy to reduce infiation.
Near the trough of the recession, Hubert Humphrey and Augustus Hawkins
sought to require that the government reduce unemployment to 3 percent
within four years after passage, that it offer employment to all who wished
at the same "prevailing wage" that Davis-Bacon mandated be paid
on government construction projects, and (in its House version) that individuals
have the right to sue in federal court for their Humphrey-Hawkins jobs
if the federal government had not provided them. In early 1976 the National
Journal assessed its chances of passage as quite good-though principally
as veto bait to create an issue for Democrats to campaign against Gerald
Ford, rather than as a desirable policy.

Arthur Burns tried to avoid getting sucked into what he
saw as a no-win situation:

Humphrey-Hawkins... continues the old game of setting
a target for the unemployment rate. You set one figure. I set another
figure. If your figure is low, you are a friend of mankind; if
mine is high, I am a servant of Wall Street.... I think that is not a profitable
game... (Wells (1994))

Humphrey-Hawkins eventually generated significant
opposition from within the Democratic coalition. Labor would not support
the bill unless Humphrey-Hawkins jobs paid the prevailing wage (fearing
the consequences for unionized public employment if the "prevailing
wage" clause was dropped); legislators who feared criticism from economists'--even
Democratic economists'--judgment that Humphrey-Hawkins was likely to be
very infiationary would not support the bill unless the "prevailing
wage" clause was removed.

The bill that finally passed and was signed in 1977:

Set a target of reducing unemployment to 4 percent by
1983.

Elevated price stability to a goal equal in importance
to full employment.

Set a goal of zero infiation by 1988.

Called for the reduction of federal spending to the lowest
level consistent with national needs.

Required the Federal Reserve Chairman to testify twice
a year.

In other words, the bill that was signed did nothing.

Economists' instincts are that uncertainty about current
prices, future prices, and the real meaning of nominal trade-offs between
the present and the future; distortions introduced by the failure of government
finance to be infiation-neutral; windfall redistributions and
the focusing of attention not on preferences, factors of production, and
technologies but on predicting the future evolution of nominal magnitudes
must degrade the functioning of the price system and reduce the effectiveness
of the market economy at providing consumer utility. The cumulative jump
in the price level as a result of the infiation of the 1970s may have
been very expensive to the United States in terms of the associated reduction
in human welfare.

By the end of the 1970s average nominal wage growth was
some eight percent per year rather than six percent per year, and the wedge
between nominal wage and nominal price growth had vanished as a result
of the productivity slowdown. Thus Paul Volcker and his Open Market Committee
at the end of the 1970s faced the problem of how to slow the rate of nominal
wage growth, and thus the rate of core infiation, by some five
percentage points per year or so. Arthur Burns and his Open Market Committee
at the beginning of the 1970s faced the problem of how to slow the rate
of nominal wage growth, and thus the rate of core infiation, by two
percentage points per year or so.

Such a permanent deceleration in nominal wage growth might
have been accomplished by shifting infiationary expectations downward
directly (so that a lower rate of nominal wage increase would have been
associated with the same rate of increase in real wages), or by triggering
a recession sufficiently deep and sufficiently long that fear
of future excess supply in the labor market would restrain demand for rapid
wage increases.

Nevertheless the existence of Humphrey-Hawkins, and the
consequent commitment of first the Carter administration and then
Carter's selection as Arthur Burns's successor, G. William Miller, to returning
the economy to full employment had unpleasant consequences. To a small
degree it was a matter of bad luck: senior Carter economic officials
have talked of the year "when our forecasts of real GNP growth were
dead on-only the productivity slowdown meant that the end-of-year unemployment
rate was a full percentage point below where we had forecast." To
a larger degree it was the result of the lack of interest and focus in
the Carter White House on infiation, in spite of efforts by economists
like Charles Schultze to warn that infiation was likely to suddenly
become a severe surprise problem in 1979 and 1980 unless a strategy for
dealing with it was evolved earlier.

Infiation did become a surprise severe political
problem in 1979. And this generated the only episode in history in which
a Council of Economic Advisers Chairman (Charles Schultze) and a Treasury
Secretary (Michael Blumenthal) waged a campaign of leak and innuendo to
try to get the Federal Reserve Chairman (G. William Miller) to tighten
monetary policy (Kettl (1986)).

No one is willing to say a good word about G. William
Miller's tenure as Chairman of the Federal Reserve. He lasted sixteen months,
and then replaced Michael Blumenthal as Secretary of the Treasury.

G. William Miller's successor as Chairman of the Federal
Reserve Board was Paul Volcker.

The Volcker Disinflation

Could the Volcker disinfiation have been undertaken
earlier? Had Gerald Ford won reelection in 1976 and reappointed Arthur
Burns, would we now speak of the Burns disinfiation? Or would the
same political pressures that had driven Nixon into wage and price controls
have driven a second Ford administration into an overestimation of the
available room for economic expansion? Herbert Stein, at least, is skeptical:
"We do not know whether a Ford administration...kept in office...
would have persisted" in a course that would have kept infiation
declining, "...but we do know that the basis for the persistence of
such a course had not been laid." And he attributes the failures of
the Carter administration and the Carter-era Federal Reserve at infiation
control "not... chiefiy a refiection of the personalities
involved... [but] a response to the prevailing attitude in the country
about the goals of monetary policy." In Stein's opinion the Federal
Reserve did not as of the mid-1970s have a mandate to do whatever turned
out to be necessary to curb infiation.

Conclusion

Examine the price level in the United States over the
past century. Wars see prices rise, by more than fifteen percent per
year at the peaks of wartime and decontrol infiation. The National
Industrial Recovery Act and the abandonment of the gold standard at the
nadir of the Great Depression generate nearly ten percent infiation.
But aside from wars and Great Depressions, at other times infiation
is almost always less than five and usually two to three percent per
year-save for the 1970s.

The 1970s were the world's only peacetime outburst of
infiation in this century. The 1970s was the only era in which business
enterprise and financing transactions were also "speculation[s]
on the future of monetary policy" (Simons (1947)) and concern about
infiation was an important factors in nearly all business decisions.

The truest cause of the 1970s infiation was the shadow
of the Great Depression. The memory left by the Depression predisposed
the left and center to think that any unemployment was too much, and eliminated
any mandate the Federal Reserve might have had for controlling infiation
by risking unemployment.

The Federal Reserve gained, or regained, its mandate to
control infiation at the risk of unemployment during the 1970s as
discontent built over that decade's infiation. It is hard to see how
the Federal Reserve could have acquired such a mandate without an unpleasant
lesson like the infiation of the 1970s.

Thus the memory of the Great Depression meant that the
U.S. was highly likely to suffer an infiation like the 1970s in the
post-World War II period-maybe not as long, and maybe not in that particular
decade, but nevertheless an infiation of recognizably the same genus.

At the surface level, the United States had a burst of
infiation in the 1970s because no one--until Paul Volcker took office
as Chairman of the Federal Reserve--in a position to make anti-infiation
policy placed a sufficiently high priority on stopping infiation.
Other goals took precedence: people wanted to solve the energy crisis,
or maintain a high-pressure economy, or make certain that the current recession
did not get any worse. As a result, policy makers throughout the 1970s
were willing to run some risk of non-declining or increasing infiation
in order to achieve other goals. After the fact, most such policy makers
believed that they had misjudged the risks: that they would have achieved
more of their goals if they had spent more of their political capital and
institutional capability trying to control infiation earlier.

At a somewhat deeper level, the United States had a burst
of infiation in the 1970s because economic policy makers during the
1960s dealt their successors a very bad hand. Lyndon Johnson, Arthur Okun,
and William McChesney Martin left Richard Nixon, Paul McCracken, and Arthur
Burns nothing but painful dilemmas with no attractive choices. And bad
luck coupled with bad cards made the lack of success at infiation
control in the 1970s worse than anyone had imagined ex ante.

At a still deeper level, the United States had a burst
of infiation in the 1970s that was not ended until the early 1980s
because no one had a mandate to do what was necessary in the 1970s to push
infiation below four percent, and keep it there. Had 1970s Federal
Reserve Chairman Arthur Burns tried, he might well have ended the Federal
Reserve Board as an institution, or transformed it out of all recognition.
It took the entire decade for the Federal Reserve as an institution to
gain the power and freedom of action necessary to control infiation.

And at the deepest level, the truest cause of the infiation
of the 1970s was the shadow cast by the Great Depression. The Great Depression
had made it impossible for almost anyone to believe that the business cycle
was a fiuctuation around rather than a shortfall below some sustainable
level of production and employment. An economy would have to have some
"frictional" unemployment, perhaps one percent of the labor force
or so, to serve the "inventory" function of providing a stock
of workers looking for jobs to match the stock of vacant jobs looking for
workers. An economy might have some "structural" unemployment.
But there was no good theory suggesting that either of these would necessarily
be a significant fraction of the labor force. Everything else was
"cyclical" unemployment: presumably curable by the expansionary
policies that economists would now prescribe in retrospect for the Great
Depression.

Sooner or later in post-World War II America random variation
would have led the economy to fall off of the tightrope of full employment
and low infiation on the over-expansionary side. Although there was
nothing foreordained or inevitable about the particular way in which America
found itself with strong excess aggregate demand at the end of the 1960s,
it was foreordained and inevitable that eventually some combination of
shocks would produce a macroeconomy with strong excess demand. And once
that happened--given the shadow cast by the Great Depression--there was
no institution with enough authority, power, and will to quickly bring
infiation back down again.

It took the decade of the 1970s to persuade economists,
and policy makers, that "frictional" and "structural"
unemployment were far more than one to two percent of the labor force (although
we still lack fully satisfactory explanations for why this should be the
case). It took the decade of the 1970s to convince economists and policy
makers that the political costs of even high single-digit infiation
were very high. Once these two lessons of the 1970s had been learned, the
center of American political opinion was willing to grant the Federal Reserve
the mandate to do whatever was necessary to contain infiation. But
until these lessons had been learned, it is hard to see how the U.S. government
could have pursued an alternative, earlier, policy of sustained disinfiation
in response to whatever shocks had happened to create chronic excess demand.

A mandate to fight infiation by inducing a significant
recession was in place by 1979, as a result of a combination of perceptions
and fears about the cost of infiation, worry about what the "transformation
of every business venture into a speculation on monetary policy" was
doing to the underlying prosperity of the American economy, and fear that
the structure of expectations was about to become unanchored and that permanent
double-digit infiation was about to become a possibility.

But the process by which the Federal Reserve obtained
its informal mandate to fight infiation by inducing significant
recession was a slow and informal one. Part of its terms of existence require
that it never be made explicit. It is difficult to imagine it coming
into being-and thus the Federal Reserve's "independence" being
transformed from a quirk of bureaucratic organization into a real and powerful
feature of America's political economy-without some lesson like that taught
by the history of the 1970s.

Today many observers would say that the costs of the Volcker
disinfiation of the early 1980s were certainly worth paying, comparing
the U.S. economy today with relatively stable prices and relatively moderate
unemployment with what they estimate to have been the likely consequence
of business as usual: infiation slowly creeping upward from near ten
toward twenty percent per year over the 1980s, and higher unemployment
as well as infiation deranged the functioning of the price mechanism.
In the U.S. today infiation is low, and the reduction of infiation
to low single-digit levels has been accomplished without the seemingly
permanent transformation of "cyclical" into "structural"
unemployment seen in so many countries of Europe.

Nevertheless, other observers believe that their ought
to have been a better way: Perhaps infiation could have been brought
under control more cheaply by a successful incomes policy made up of a
government-business-labor compact to restrain nominal wage growth (which
certainly would have been in the AFL-CIO's interest, as it is harder to
think of anything worse for that organization's long-term strength than
the 1980s as they actually happened). Perhaps infiation could have
been brought under control more cheaply by a Federal Reserve that did a
better job of communicating its expectations and targets; but note that
the dispute over whether "gradualism" (in the sense of the British
Tory Party's Medium-Term Financial Strategy; see Taylor ()) or "cold-turkey"
(see Sargent (1982)) was the most cost-effective way of reducing infiation
has not been resolved; it is hard to fault those who made economic policy
decisions when even those economists with ample hindsight do not speak
with one voice.